Preferred Stock Funds vs. Bond Funds

As we know, an investor’s portfolio can’t only contain stocks that he or she hopes will increase in value. While capital gains are great, fixed-income should never be neglected. In fact, as an investor gets closer to retirement a larger percentage of his or her portfolio should be allocated towards fixed-income securities, whether they be preferred stock funds or bond funds.

Preferred Stock Funds

Preferred stock funds are mutual funds made up of preferred stocks. Preferred stocks are a neat hybrid between common stocks and corporate bonds that carry the benefits and downsides of each. While preferred stocks have a fixed dividend and represent a piece of ownership in the company, the shares do not generally come with voting rights. On the other hand, the company’s success is not reflected in the price of a preferred share.

Preferred stocks are callable loans to investors but have no guarantee of redemption and can literally last the entire life of the company – a feature that is helpful for a company that has issued shares with low dividend payments in a world of rising interest rates. As the interest rate increases, the price of preferred shares will decrease to make the yield more attractive to investors.

Bond Funds

Bond funds are mutual funds made up of bonds. Bond prices act similarly to preferred shares with regards to the interest rate: if rates rise, the yield will need to increase for the bonds to appear more attractive. Bonds, however, do have a set date by which the company must repay the bond (the maturity date). In this way, investing in bond funds means that the investor has a better sense of how long the fund will be invested in a particular company.

Unfortunately for bond funds, the tax code hasn’t quite closed the gap between the two types of mutual funds. Preferred stock fund payments are treated and taxed as dividends, resulting in a lower tax bill than a similar coupon payment from bond funds.

Who Should Own These Funds?

Preferred share funds and bond funds are great products for investors looking for a stable, fixed income. Regardless of the potential capital gains or losses, younger people should be more heavily invested in preferred shares simply because of the increased risk. Younger investors have a longer time to grow their portfolio and benefit from the magic of compounding. With a longer time frame in which to invest, riskier preferred stock funds, their corresponding higher returns, and generally lower MER fees will grow substantially more than a bond fund.

For example, the Dynamic Preferred Class Yield Fund has an MER of 1.79%, returned 7.5% in 2014, and distributes 0.36% a month. The Dynamic Corporate Bond Strategies Fund has an MER of 1.81% but had a much lower return of 3.7% in 2014 and a monthly distribution of 0.34%. Retirees can feel comfortable with a bond fund that comes with a decent monthly payment but younger investors should shy away from a bond fund that returns 4% less than a slightly riskier preferred stock fund.

But remember, in the event that a company is having financial difficulties, preferred share payments can be suspended. And in the case of liquidation, bondholders are paid ahead of the preferred shareholders.

The Bottom Line

As with most things in life, investors have many options when it comes time to make a decision. Although preferred stock funds and bond funds share many similarities, preferred stock funds have higher returns to counteract the elevated risk involved in holding them. While retirees should load up on bond funds to satisfy the fixed-income portion of their portfolio, younger investors should stick to preferred stock funds.

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